Submissions on the Department of Internal Affairs’ Modernising the Charities Act 2005 Discussion Document (Discussion Document) close on 31 May 2019.
One of the four main risks for established charities identified in our article last month is the spotlight on the commercial activities of charities, and whether regulation of charitable businesses needs to be changed.
Any law reform in this area of law would likely have a large impact on the way many charities, and the charitable sector in New Zealand, function.
In this article we look at the possible reform options.
Background to charities as a business
Businesses operated by charities are a key income source for many New Zealand charities. Much of the $2.9 billion of trading income that is applied to charitable purposes in New Zealand each year is earned through businesses run by charities.
Despite charitable businesses being relatively commonplace, the current Charities Act does not provide any explicit rules for how they should operate. The only legislative regulation is by way of provisions such as section 13 of the Charities Act 2005, which prohibits a charity from operating to profit an individual. Case law clarifies that charities may only operate businesses if all profit is applied exclusively to charitable purposes. Beyond these requirements, charitable businesses remain largely unregulated in New Zealand.
Those in favour of the status quo will argue that without the charitable business contribution to the economy, the government and taxpayer would need to step in to replace a large part of that contribution. The majority of charities contribute to, and arguably subsidise, many areas of interest to the government (such as health, social services and housing).
Those who promote law reform of charitable business say that charities have an unjustifiable competitive advantage with tax breaks and that business activities of charities create unnecessary risk to the asset base and reserves of charities. There is also a call for more reporting transparency for charitable businesses.
Possible reform options
We anticipate that there are likely to be three reform options considered by the Department of Internal Affairs:
- Whether unrelated businesses should be entitled to charitable status at all (a North American model);
- Whether an assessment of risk of an unrelated business is required (an England and Wales model);
- Whether financial reporting reform is required for increased transparency.
We comment on each of these below.
1. Whether unrelated businesses should be entitled to charitable status
The Discussion Document is particularly concerned with businesses that are not directly contributing to charitable purposes, these being termed an ‘unrelated business’. Charities commonly run businesses that are unrelated to their cause, but then use the funds generated for their charitable purpose. For example, a charity that provides hospice care might run an op-shop that sells second hand items and use the revenue to support its charitable purposes.
In the United States, unrelated businesses are prohibited from registering as a charity at all – they must be “substantially related” to the purpose of the charity. In Canada, charitable organisations can lose their registration if they carry out an unrelated business – they need to be operated in a separate vehicle that is subject to standard income tax. The position is similar in Ireland.
Australia’s position is the same as New Zealand currently, while England has a more complex system that sits somewhere in the middle.
We see the distinction between a business that supports the purpose and one that is unrelated as problematic. Issues arise for example where a government funds or contracts a bundle of social services, some of which will fall within a charity’s purposes and some that do not.
We think that introducing an exclusion from tax exemptions for unrelated business activity would introduce another layer of compliance to manage and fund. It would also likely see a reduction of activity and services provided in the charity sector and therefore reduce the funds that are applied to charitable purposes in New Zealand.
2. Whether an assessment of risk of an unrelated business is required
There is a policy concern that confidence in the charitable sector may be undermined if businesses operated by charities experience business setbacks or failures. For this reason, charity law in England and Wales does not permit charities to directly carry out non-primary purpose trading where there is a significant risk to the charity’s assets.
In New Zealand the flexibility of our regime can address this concern by permitting subsidiary limited liability companies of charities to have the benefits of the charity regime while at the same time enjoying the reduced trading risk of a limited liability company. This approach can effectively manage the risk that the law of England and Wales is concerned with. As an aside, many charities in New Zealand are structured with wholly owned limited liability companies to mitigate risk although this is structure is probably not used enough across established New Zealand charities.
We also consider that governance obligations being introduced in the Trusts Bill and the new Incorporated Societies Act over the next year or so will help to manage the risks through a better standard of governance and better accountability.
As with the previous option, we consider there would be increased compliance costs and a reduction in the contribution of the charitable sector to New Zealand if a risk assessment test was introduced.
3. Whether financial reporting reform is required for transparency
Many charities, especially larger ones, can have complex structures that include a number of subsidiary businesses. These subsidiaries apply profits to their parent charity and so can benefit from the tax exemptions that their parent charity has the benefit of.
As it stands, the Charities Act 2005 requires charities to report on all organisations that they control in consolidated financial statements. These statements provide information about the charity and the organisations it controls as though it were one entity.
The Discussion Document raises a concern that consolidation can reduce transparency. It suggests that consolidated financial statements may not contain all the information needed to fully assess the financial well-being of business subsidiaries of a charitable group. Consolidation may also obscure transactions between the charitable arm and business arm of a charitable group. It may not be clear if transactions between the charitable and the business arms are furthering a charitable purpose.
From our experience there are often good reasons for a charity not to disclose their accounts to the public, for example, for commercial sensitivity reasons or where private charities do not want public disclosure of wealth. These entities are generally comfortable with disclosure to the regulator, they are just uncomfortable with the public disclosure. Such publication is not required by most private companies.
Our view is that while disclosure to the regulator to ensure compliance is reasonable, public disclosure of business accounts beyond the status quo, is not required to maintain confidence in the charitable sector. Consolidated accounts are sufficient to show solvency and how funds are applied to the charitable purpose.
Summary – our view
While the application of all funds generated by an unrelated business toward a charities purpose should always be non-negotiable, we are of the view charities function best in an environment that allows them to raise funds in a flexible way and in a similar framework to that enjoyed by the private sector.
We think the status quo position serves New Zealand well for the following reasons:
- Many charities already manage risk well through their existing structures, especially by utilising subsidiary limited liability companies;
- The governance obligations being introduced in the Trusts Bill and the new Incorporated Societies Act over the next year or so will impose a higher level of governance standards on trustees and boards to manage the risks. Directors of charity subsidiary boards are also already subject to director duties imposed by the Companies Act 1993; and
- The income and profits of charitable sector help support the New Zealand economy. Any throttling of that support will likely result in the government having to step in with taxpayer funds to replace the reduction in funds generated and applied to charitable purposes.
All charities that have business activities supporting their purposes should ensure they make a submission on the Discussion Document by 31 May 2019.
If you have any questions, please contact Scott Moran. Scott acts for some of New Zealand’s most iconic charities in the disability, youth and vulnerable support sectors. He assists the charities he works with in a wide range matters including constitutional, compliance, contractual, property and IP matters.
Disclaimer: the content of this article is general in nature and not intended as a substitute for specific professional advice on any matter and should not be relied upon for that purpose.